TOOL KIT

Much

Com pany
N ? by Richard Passov
L
More than you think-a lot more-if yours is a knowledge-based
corporation. That's because you need to provide for intangible
liabilities-the investments a company has to make to realize
the benefits of its knowledge.

A F T E R ITS MERCER with rival thereby unlocking tremendous value

^ j L Warner-Lambert in 2000, New
/ \ York-based pharmaceutical
giant Pfizer found itself sitting on a net
cash position approaching $6 billion.
That seemed extraordinarily conser-
vative for a company whose products
generated close to $30 billion in reve-
nues. Those products included some of
the world's best-selling drugs. The anti-
cholesterol blockbuster Lipitor alone
generated worldwide revenues in excess
of $7 billion in 2001.
Most large companies with revenues
tbat healthy would increase their lever-
age, or the amount of debt they carry,
for their shareholders, both from tax
benefits and from the market's well-
documented perception that managers
with less money to spend will spend it
more wisely. Consider Bank of America.
Its capital structure, like that of most
banks, relies heavily on debt The value
of the tax shields alone accounts for
approximately one-third of the com-
pany's $120 billion market capitaliza-
tion. But is this kind of strategy appro-
priate for a knowledge-based company
like Pfizer? To answer that question,
Tim Opler of Credit Suisse First Boston
and I undertook an in-depth study of

NOVEMBER 2003 119

TOOL KIT • How Much Cash Does Your Company Need?
the knowledge-based businesses that
were most closely comparable to Pfizer.
Tbere, we saw a rather different picture:
The world's largest and most successful
technology and life sciences companies
were consistently holding significant net
cash positions.
Like Pfizer, these companies had mar-
ket valuations that were much greater
tban tbe value attributable to their on-
going businesses, a premium that re-
flects these companies' ability to create
new products through R&D. And like
Pfizer's, tbese companies' assets were
very risky-a fact often obscured by the
companies' balance sheet structure.
Pfizer shares, for example, had approxi-
mately the same price volatility (30%) as
tbose of Bank of America in 2001. But
Pfizer had a negative leverage ratio of
0.3:1 where Bank of America bad a ratio
approaching io:i. If the equity volatili-
ties are adjusted to eliminate the effect
of the two companies' balance sheet
structures-treating both companies as
if they were wholly equity financed and
had no cash - we see that Pfizer has an
underlying asset volatility of close to
30% while Bank of America has a vola-
tility closer to 5%. Because of tbis higher
underlying volatility, Pfizer and the
other knowledge companies we looked
at were in a group apart from other
large corporations.
We believe that these companies'
decisions to run large cash balances is
one of the key factors in sustaining the
value of their intangible assets-which
typically comprise a substantial portion
of overall valuations for knowledge
companies. Only by consistently invest-
ing in their intangible assets can knowl-
edge companies hope to preserve the
value of those assets. A company that
finds itself unable to meet such com-
mitments because unfavorable market
conditions reduce its operating cash
fiows will find its share price suffering
almost as much as if it were to default
on its debts. By the same token, with
the right balance sheet, knowledge com-
panies can profitably insure against the
Richard Passov is the treasurer of Pfizer.
He is based in New York.
120
risk of failing to sustain value-added in-
vestments in difficult times. An optimal
capital structure that calls for significant
cash balances is at odds with the results
of a traditional capital structure anaiysis
but explains the financial policies of
many well-run knowledge companies.
Funding the Intangible
To see why knowledge companies aren't
suited to traditional capital structures,
consider again Pfizer. In mid-2001, the
company's market valuation was in ex-
cess of $200 billion. Of that amount.
Wall Street analysts estimated that more
than 30% was derived from the com-
pany's R&D pipeline and its worldwide
branding and marketing capabilities.
A large portion ofthe drug pipeline was
in advanced stages of development, but
significant investment and risks were
still associated with realizing the po-
tential value. Furthermore, a great deal
of value was attributed to early-stage
development projects. Indeed, looking
forward, Pfizer's anticipated revenue
stream relied more and more on prod-
ucts yet to be developed and less on
those already being marketed.
Pfizer's intangible assets are the prod-
uct of heavy ongoing investment. The
company's R&D alone consumes about
$7 billion a year. What's more, the pro-
ductivity ofthe company's research sci-
entists depends on maintaining a vast,
interconnected IT infrastructure. Such
investments are not treated as liabili-
ties in a traditional capital structure
analysis. To see why that's a problem,
consider what would happen if Pfizer
found itself in a situation where inter-
nally generated funds could no longer
sustain R&D. Finance theory maintains
that the market will always be willing
to provide funds for a good investment
opportunity. Based on that reasoning,
companies with promising pipelines
should always be able to find funding
for R&D. History has shown, however,
that in times of need, external financing
can be exorbitantly expensive or simply
unavailable for knowledge companies.
Intel experienced just such a funding
crisis in the early 1980s. At that time,
the company's 80286 microprocessor
chip had just emerged as the key hard-
ware component for IBM's burgeoning
personal computer business. Unfortu-
nately, Intel was at the same time in-
volved in producing DRAM memory
chips, which were becoming commodi-
tized due to competition from Japanese
manufacturers. Intel's cash position
dwindled and its debt rose to the point
where the company was unable to make
the capital expenditures necessary to
complete the development of its micro-
processors. Intel was forced to raise new
equity capital from its primary business
partner, IBM, which purchased 12% of
the company for $250 million. The cap-
ital infusion allowed Intel to continue
its R&D program and build manufac-
turing plants for new microprocessors
while simultaneously sustaining a costly
transition awayfromthe DRAM market.
Arguably, Intel's inability to meet its
R&D commitment cost its shareholders
as much as a debt default would have.
Like a debt crisis, the funding crisis had
forced the company into financial dis-
tress. Had Intel not shrewdly repur-
chased the stake in the late 1980s, by
2001, IBM would have earned a 100-fold
increase on its initial investment.
Of course, Intel and Pfizer are not the
only companies that have large capital
commitments. Oil companies, for exam-
pie, spend huge amounts of money on
exploration and development. Yet they
often use more leverage and seem less
vulnerable to the whims of the capital
markets. The difference in financial
strategies seems to lie in two important
distinctions between tangible and in-
tangible assets. These factors also ex-
plain the relatively high asset volatility
of Intel, Pfizer, and other successful
knowledge-based companies.
Intangible assets are company de-
pendent. The value of tangible assets-
even those that require considerable
investments to exploit-is usually widely
recognized by outside investors. An oil
reserve, for example, has a generally
agreed-upon value, regardless of the
company that owns it. Energy giant
ChevronTexaco has to spend billions
to exploit its reserves. But because the
value of those reserves can be estimated
HARVARD BUSINESS REVIEW
TOOL KIT • How Much Cash Does Your Company Need?
and easily communicated, the company
usually can find the money to fund de-
velopment regardless ofthe state of its
finances. By contrast, the value of a com-
pany's intangible assets is typically un-
derstood only by the company itself or
its close partners. If the company fails
to invest in maintaining the value of its
intangible assets, no one else is likely to
volunteer. In other words, the value of
intangible assets is highly dependent on
a company's own ability to fund those
assets, while the value of tangible assets
is independent of the company, [n
Intel's case, nobody had any idea in 1983
what a huge market microprocessors
would become, which explains why the
company could obtain funding only on
expensive terms from IBM. This experi-
ence cast into sharp relief the value of
holding cash reserves, and Intel went on
to build a strong balance sheet to pro-
vide insurance against potential futtire
funding needs.
Intangible liabilities cannot be
hedged. The second reason intangible
Determining the Optima! Capital Structure
This chart shows how the benefits of debt evolve as leverage increases for
a company with a 35% corporate tax rate. At first, enterprise value rises in a
straight line with debt-each dollar of debt yielding 35 cents of extra value
for the company. But as the costs of financial distress kick in, the line starts
to curve, flatten, and eventually fall, reflecting the increasing severity of ex-
pected distress costs. The top ofthe curve marks the optimal netdebt-to-
cash position for tbat company.
Enterprise Value
122
assets are different from tangible ones
is that the risk that a company will be
unable to meet commitments on intan-
gible assets cannot be easily hedged.
The value of an oil company's explora-
tion and development budget is subject
to the variable market pricing of oil; a
sharp fall in oil prices reduces the value
of those projects. However, the risk of a
fall in oil prices can be hedged in the fi-
nancial markets, which allows the com-
pany to preserve the value of its explo-
ration and development projects even
when business conditions deteriorate.
Even if it decides not to protect its ex-
ploration and development projects in
this way, the company enjoys a natural
hedge because the price of oil is highly
correlated with cash fiows. When the
firm's cash fiows are low, so is the ex-
pected value of exploration and devel-
opment. That means the company is
most likely to be short on funds when
it least needs to spend the money on
the asset. By contrast, a knowledge com-
pany's primary risk - whether or not
contribution of
debt to enterprise
value without
financial distress
costs
contribution of
debt to enterprise
value including
financial distress
costs
Net Debt
the various molecular compounds in
its pipeline will react as hoped, for ex-
ample - is impossible to hedge in the
financial markets. That risk is also un-
likely to be correlated with the com-
pany's cashfiows.A particular molecule
may react as planned, but the company
may run out of funds before discovering
that. Unlike an oil company, therefore,
a pharmaceutical company may face a
funding crisis just when the value of
continuing its research is highest. The
only way to manage that risk is to en-
sure that the company always has on
hand enough liquid assets - essentially,
cash-to meet its R&D liabilities.
If the defining characteristic of a lia-
bility is that the company's inability to
meet it triggers financial distress, then
it is only logical that R&D expenditures
of Intel, Pfizer, and their peer companies
should be considered liabilities-just
as inescapable a commitment as if they
were a debt obligation. Companies do
not currently treat R&D and compara-
ble investments in intangible assets
as balance sheet items. But from an
economic perspective, they probably
should. After all, ifthe market is placing
a value on the promise of future success
in drug discovery, for example, it is also
expecting that the resources necessary
to discover these drugs will be available
to spend as needed.
Reoptimizing the
Balance Sheet
Once a company's intangible assets -
and the unhedgeable liability associ-
ated with them-are recognized as being
capable of causing financial distress, a
key input variable into the calculation
of optimal capital structure changes.
Traditionally, companies determine the
optimal capital structure by calculating
the point at which the expected costs of
financial distress from the likelihood
of defaulting on debt begin to outweigh
the tax benefits of debt - unlike divi-
dends, debt interest payments are tax
deductible. (See the exhibit "Determin-
ing the Optimal Capital Structure.")
Let's look at the numbers in more
detail. The tax benefit, or tax shield as
it is usually called, is determined by the
HARVARD BUSINESS REVIEW
TOOL KIT • How Much Cash Does Your Company Need?
corporate tax rate: Simply multiply the
amount of debt by the marginal corpo
rate tax rate. Arriving at the cost of de-
faulting on debt is a bit more compli-
cated: The probability that the company
will not be able to meet its debt obliga-
tions is multiplied by the likely impact
of that default, should it happen, on the
company's value. One practical way to
estimate the probability of default is to
look at the historical volatility of a com-
pany's cash fiows. From that, you can
determine through statistical analysis
how frequently a company's cash fiows
are likely to be less than the level of in-
terest payable for a given level of debt.
Obviously, the greater the size ofthe in-
terest bill, the higher that probability. If
The Impact of Distress Costs by Industry
O u r research shows t h a t companies w i t h a preponderance o f intangible assets are m o s t vulnerable t o financial
distress. Knowledge-intensive industries such as higb technology and life sciences lose up t o 80% o f enterprise
value in times o f financial distress, w h i l e tangible-asset companies, like those in p e t r o l e u m and railroads, lose
as I ittle as io%, on average.
Loss of
Enterprise
Value due to
Financial
Distress
50%
20%
10% Agriculture
Forest
Products
Metals
Power
Generators
Railroads
Tobacco
(low)
124
a company's historical cashfiowsare not
available, analysts can use industry data
or empirical studies that provide default
rates. Debts rated Aaa by Moody's, for
instance, have historically had a o.i%
chance of defaulting within five years,
a Baa rating a 1.8% chance, and a B rat-
ing a 32% chance. A more ambitious an-
alyst could also use default rates implied
by an analysis of spreads on corporate
bonds or credit derivatives.
The impact of default can be esti-
mated by looking at the empirical data.
Research shows that a typical company
will lose roughly 20% of its enterprise
value (market value of the company's
shares plus the value of its debt less
cash) in times of financial distress. Mul-
Branded
Consumer
Auto Parts Products
Ca5inos Defense
Chemicals Hospitals
Oil and Gas Hotels
Steel Media
Trucking Retailing
Utilities Telecom
relative importance of intangible assets
tiplying this number by the probability
of default determined above produces
the expected cost of default, or the
amount a company would want to in-
sure itself for, if it could. So for an aver-
age company with a default probability
of 5% over a five-year horizon, the ex-
pected cost of default, over that same
time period, would be i% of the firm's
enterprise value.
The underlying assumption in using
this method of calculating optimal cap-
ital structure is that a company's debt
level is the principal determinant of
whether or not a company will suffer
financial distress. But as we've argued,
a company can lose just as much value,
if not more, if it cannot fund the intan-
Biotechnology
Pharmaceuticals
Proprietary
IT Hardware
Software
Airlines
Auto
Manufacture
Financial
Services
Professional
Services
Specialty
Instruments
(high)
HARVARD BUSINESS REVIEW
 How Much Cash Does Your Company Need? • TOOL KIT

Pfizer's Optimal Capital Structure

Incorporating intangible liabilities into the determina-
tion of capital structure dramatically changes how a
company's debt-to-cash position contributes to enter-
prise value. The grapb below compares tbe contribution
of cash and the contribution of debt to Pfizer's enter-
prise value. The straight line represents the impact in
terms of tax benefits of holding cash or debt, assuming
no financial distress costs. Tbe blue curve-resulting
from the traditional method of calculating optimal
capital structure-tracks tbe net contribution to Pfizer
of holding debt (tax benefits less distress costs due to
debt). The green curve tracks the net contribution to
Pfizer's enterprise value of holding cash (insurance
value iess tax disadvantage from holding cash). As tbe
graph shows, the contribution ofthe insurance value
of cash is greater tban tbe contribution from the tax
shields of debt, which means that Pfizer should cboose
the optimal position on the net cash curve. For a com-
pany with heavy tangible assets, by contrast, tbe contri-
bution to enterprise value of debt would dominate the
insurance value of casb, in which case tbe optimal capi-
tal structure would be driven by the debt curve.

Enterprise Value
tax impact of debt/cash y^
on enterprise value y^

contribution of cash
to enterprise value ^.dSv
y^ contribution of debt
y _^ to enterprise value
/^^---''''''''^^^^
/ \
Net Qz%\\y^ y" Net Debt

gible liabilities associated with its in-
tangible assets. In other words, financial
distress costs can kick in even while a
company has a nef-cash position. On
that basis, the calculation needs to be
adjusted. First, the probability of de-
fault must be adjusted to encompass
the probability of distress: It should be
determined not by the probability of
interest costs exceeding cash fiow but
by the probability of interest costs plus
R&D expenses (or other capital expen-
ditures) exceeding cash fiow. Similarly,
the impact of default must be adjusted
to refiect the fact that the value of in-
tangible assets tends to be much more
volatile than that of tangible ones and
their higher volatility exposes the com-
pany to greater financial risk.
Recalculating Distress Probability.
The adjustment for this is quite simple,
since all you are doing is raising the casb
fiow bar. In effect, you're increasing in-
terest costs by the size of your R&D bud-
get, or at least that portion of it for
which it would be difficult to obtain ex-
temal financing on reasonable terms.
Applying historical cash fiow volatility
to this new number gives you the prob-
ability of distress due to default on in-
tangible liabilities.
Companies may wish to make even
more precise estimates. At Pfizer, for

NOVEMBER 2003 125

TOOL KIT • How Much Cash Does Your Company Need?
instance, an analysis of our historical
cashfiowsallows us to quantify the im-
pact of losing patent protection on cur-
rently marketed products. Another key
risk we consider is the possibility that a
drug might be withdravfli from the mar-
ket due to safety concerns. To account
for that, we use industry data to model
the likelihood of an approved drug
being pulled from the market.
Recalculating Distress Impact. In-
tangible assets tend to be more volatile
than tangible ones, so one would expect
companies with substantial intangible
assets to suffer more infinancialdistress
than companies whose assets were
largely tangible. Our own empirical re-
search confirms this. We found that the
extent of value loss during a period of fi-
nancial difficulty is positively correlated
to a company's underlying business
risk-that is, its asset volatility. (See the
exhibit "The Impact of Distress Costs by
Industry.") When calculating the impact
of distress costs, companies must take
this higher volatility into account.
Running the numbers for Pfizer, we
found that the company's optimal capi-
tal structure - the structure that maxi-
mized the company's value - called for
holding a positive netfinancialbalance,
as shown in the exhibit "Pfizer's Optimal
Capital Structure." That stands in sharp
contrast with the optimal capital struc-
ture predicted by a conventional ap-
proach - a net debt position entirely
inadequate to maintain the value of
Pfizer's intangible assets.
Beyond Pfizer
Our mode! does not apply only to
knowledge-based firms; it can be used
to calculate the optimal capital struc-
ture of all types offirms.Consider again
ChevronTexaco, which has $99 billion
in annual revenues, nearly $10 billion in
cash fiow from operations, and annual
capital expenditures approaching $8 bil-
lion in 2002. While the company has
comparable capital outlays to those of
Pfizer, it does not rely nearly as heavily
on intangible assets.
The bulk of ChevronTexaco's capital
commitments consists of exploration
and development expenditures. As we
126
have pointed out, development costs
can be easily hedged. Exploration, how-
ever, counts as a true liability. To calcu-
late the probability of distress at various
levels of leverage, therefore, we looked
atthe volatility of ChevronTexaco's cash
flows and applied that to the combined
average historical interest and explo-
ration costs. To estimate the impact of
financial distress, we looked at our em-
pirical data, which showed that oil com-
panies typically lose about 20% of their
enterprise value in times of distress. Our
analysis indicated an optimal net debt
level of approximately $10 billion for
the company. This compares with
ChevronTexaco's actual net debt posi-
tion of $12 billion as of year-end 2002.
Managing the Cash Position
Tbe way in wbicb companies create
and manage tbeir optimal cash (or
debt) positions can make a difference
to shareholder value. If a company
issues short-term debt and holds tbe
proceeds on the balance in matching
short-term investments, for instance,
it will create no value in terms of man-
aging its business risks. On tbe other
band, a company that borrows longer
term and invests at a shorter term
creates a pool of liquidity that can be
accessed to cover cash flow shortfalls
until the debt matures. By reducing
the risk of default in this way, compa-
nies increase their overall value. This
is one reason why automotive and
finance companies often borrow with
maturities that are longer than the
assets they hold.
In deciding how to manage a com-
pany's net cash, the first rule Is to make
sure that the asset you invest in is not
subject to the same risks as those you
are insuring against with that cash. A
technology company that holds cash
to ensure the completion ofa multi-
year development project even when
its core business is failing sbould not
invest those funds in other related
technology companies. That doesn't
A conventional model based on the
weighted average cost of capital ap-
proach would suggest that Chevron-
Texaco should have debt in excess of
$20 billion. Clearly, our model does a
better job of explaining tbis well-run
company's financial policy.
Does our model always find that tra-
ditionalfirmscan operate with leverage
while knowledge-basedfirmsshouldn't?
Not necessarily. Consider the case of
Oracle, the enterprise software giant
that had nearly $9.7 billion in revenues
in 2002. Approximately 60% of Oracle's
revenues come from licenses associated
with its software, while nearly 40% come
from product support and consulting
services. To counter fierce competition
mean, however, that you should avoid
investing your cash in risky assets al-
together. On the contrary, by avoiding
risky assets, your company may well
miss out on valuable opportunities.
Imagine that your company has
determined that it is too highly lever-
aged and starts reducing its debt by
adding to its cash position. Each extra
dollar of cash confers a marginal ben-
efit in that it lowers the company's
expected distress costs. But that mar-
ginal benefit will gradually fall until
the company achieves its optimal cash
position, after which the marginal
benefit of holding an extra dollarof
cash turns negative, because the bene-
fit of a dollar ofdebt starts to outweigh
the benefit of a dollarof casb. The first
dollarof cash,therefore, makes more
difference to the company's overall
value than the last dollar of cash.
Given that difference, we believe that
it makes sense for a company to allo-
cate its cash position to refiect the dif-
ferent values of each dollar held as
cash. Because the first dollar Is worth
the most, it should be invested in the
safest possible asset. By the same
token, it may make sense to put the
last dollar of cash in a riskier security.
HARVARD BUSINESS REVIEW
TOOL KIT • How Much Cash Does Your Company Need?

from giants like Microsoft and IBM, as
well as newer competitors like SAP,
Siebel, and PeopleSoft, Oracle invests
considerable sums in R&D, marketing,
and training. More than io% of annual
revenues are committed to the research
and development of new products. In
2001 and 2002, the company spent over
$1.4 billion each year on capital expen-
The value of intangible assets is highly dependent on a
company's own ability to fund those assets, while the
value of tangible assets is independent ofthe company.
ditures and R&D. To determine the
probability of default for various net
cash-to-debt scenarios, we used histori-
cal cash fiow volatility, analysts'projec-
tions for the company's future debt, and
R&D expenditures. To estimate the im-
pact of default, we looked at the cost for
companies with asset volatility compa-
rable to Oracle's.
Our analysis suggested an optimal net
cash position of approximately $i bil-
lion, which contrasts with Oracle's ac-
tual net cash position of around $6 bit-
lion. This finding raises some strategic
questions. If current predictions about
the slowing growth potential in the
software industry come to pass, then
there may come a time when even Ora-
cle shareholders would fare better with
a nice, steady dividend and leverage in
the company's capital structure. (It is
interesting to note that Oracle's move to
acquire PeopleSoft, were it funded by
debt, would bring its net cash position
much closer to the optimal level pre-
dicted by our model.)
Business strategy and financial strat-
egy are inextricably linked. Therefore,
companies must develop capital poli-
cies in light of their business risks. In-
deed, balance sheet management is
best viewed as a form of risk manage-
ment to be coordinated with the other
ways in which companies manage busi*
ness and financial risks. Johnson &
Johnson's consumer products business,
for example, has had strong and stable
operating cash fiows, which tend to
buffer the potential liquidity require-
ments of the company's riskier phar-
maceutical business. As a result, John-
son & Johnson can afford to have a
smaller financial asset position than
would a pure-play pharmaceutical com-
pany. (For more on the risk implications
of balance sheet structure, see the side-
bar "Managing the Cash Position.")
Intangible assets are the "dark matter"
of the business universe. Since we can
only observe them by their effects, it's
difficult to understand and catalog
them, which is precisely why the ac-
counting balance sheet differs from tbe
economic one. Accountants like to deal
in concrete fact, while economists are
happy enough with theory. But even ac-
countants cannot deny that the effects
of intangible assets are far-reaching. The
ability of intangible assets to influence
the likelihood and degree of financial
distress through the liabilities they cre-
ate is not the least important of those
effects. By suggesting ways to measure
the effects, we hope to have made a
small contribution toward incorporat-
ing intangible assets into capital struc-
ture analysis. ^
Reprint R03nj
To order, see page 141.

"You've been a great mentor, Mr Franks, but I can take it from here."

128 HARVARD BUSINESS REVIEW

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